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At the core of most pension fund investment portfolios is an allocation to equities and government bonds, with risk typically dominated by the former. Recognizing this lack of diversification, some plans have moved to a more balanced risk allocation by directly adopting a risk budget based approach or by allocating to externally managed risk parity funds. At Fulcrum, we have been building risk parity portfolios for many years, and this paper summarises our approach, along with the key lessons we have learned. Risk parity portfolios have generally outperformed equity/bond balanced portfolios in Sharpe ratio terms over the past two decades, and this has continued to be the case since the financial market shocks in 2008. In this paper, we comment on the selection of assets to include in risk parity portfolios, their performance, the appropriate treatment of volatility and correlations in building these portfolios, and the relationship between risk parity portfolios and traditional portfolios. We believe that the risk parity approach represents a valuable addition to traditional investment management techniques, especially if risk parity portfolios are combined with alpha seeking trading strategies, and are hedged against severe losses using a permanent options based overlay. We will analyse these alpha generators, and hedging strategies, in future research papers.
Introduction
Risk parity1 portfolios have delivered strong returns over the past twenty years, with a Sharpe ratio that has been higher than traditional portfolios of equities and bonds. Figure 1: Historical Excess2 Performance (Jan-93 to Sep-12)
Annual Excess Return Volatility Sharpe Ratio Correlation with: Equity Premium Bond Premium Equity/Bond
500
400
300
Global Equities 200
Global Bonds
100
0 1992
1994
1996
1998
2000
2002
In Figures 1 to 4, we include the following premia in the risk parity portfolio: Equity Premium, Bond Premium, EM $ Debt Spreads, High Yield Spreads, Commodity Beta, Emerging Equities (EM - DM), Equity Style (Value - Growth), Equity Size (Small - Large), Fixed Income Carry, Commodity Carry, Developed Market Currency Carry and Emerging Market Currency Carry. 2 Performance is expressed on an unfunded basis, i.e. without including the return on cash.
Even since the financial crisis began in early 2007, risk parity portfolios have continued to generate attractive risk-adjusted returns. Figure 3: Historical Excess Performance (Jan-07 to Sep-12)
Annual Excess Return Volatility Sharpe Ratio Correlation with: Equity Premium Bond Premium Equity/Bond
Global Bonds 120 110 100 90 80 Global Equities 70 60 50 Dec-06 Global Balanced 60/40
Dec-07
Dec-08
Dec-09
In our opinion, it is likely that risk parity portfolios will continue to outperform traditional portfolios over the long term, but there are many issues related to their construction that need to be carefully addressed.
Return Source Traditional (Long Only) 1 Equity Premium 2 Bond Premium 3 EM $ Debt Spreads 4 High Yield Spreads 5 Commodity Beta Alternative (Long Short) 6 Emerging Equities (EM - DM) 7 Equity Style (Value - Growth) 8 Equity Size (Small - Large) 9 Fixed Income Carry 10 Commodity Carry 11 Developed Market Currency Carry 12 Emerging Market Currency Carry 13 Volatility
Asset Class Equity Fixed Income Fixed Income Fixed Income Commodity Equity Equity Equity Fixed Income Commodity Currency Currency Equity & FI
The main criteria on which we judge whether these return sources should be included in risk parity portfolios are as follows: Have they provided positive Sharpe ratios historically? Do they offer a genuine risk premium? Do they exploit a behavioural anomaly? Do they provide diversification benefits to portfolios dominated by equity risk?
Bond Premium
Commodity Carry
Equity Premium
Commodity Beta
EM $ Debt
EM-DM Equities
Equity Style
Equity Size
High Yield
FI Carry
The key highlights are as follows: Over the full sample period, all risk premia have generated positive Sharpe ratios, with the exception of the equity style premium. The long term performance of credit premia (high yield bonds and emerging market debt) is disappointing, especially given the fall in credit spreads and high yields offered by these assets. (We explain some of the reasons behind this later.) The bond, fixed income carry and commodity carry premia have performed best and most consistently.
The volatility premium has a very high historical Sharpe ratio. However, the Sharpe ratio can be a misleading way of evaluating short volatility strategies.
DM FX Carry
EM FX Carry
Risk-adjusted returns delivered by currency carry premia have dropped versus their prior history, but remain positive. Since 2007, only the equity and equity style premia have generated negative Sharpe ratios.
Are you confident these risk premia will perform in the future?
Identifying genuine risk premia is a challenging exercise that requires judgement. Of the thirteen premia listed in Figure 5, we are confident that ten will compensate investors for assuming specific forms of risk, such as real interest rates, inflation, default, growth and insurance (see Figure 20). The remaining three premia exploit behavioural biases, for example those that stem from leverage aversion (currency carry premia) or information asymmetry (equity size premium). Although we believe that all thirteen premia have a valuable role within liquid risk parity portfolios, our confidence in three of the premia is slightly lower than in the others. As a result, we deviate from strict risk parity and allocate moderately lower risk budgets to them. These risk premia are as follows: Commodity beta; by investing in commodity futures it is possible to gain exposure to changes in commodity spot prices and the return associated with carry, which relates to potential gains made from owning commodities for which forward prices are lower than current spot prices. Over the very long term, returns from commodity futures have been dominated by the carry return while spot prices have generally provided an insignificant contribution, especially in real terms. Currently, most commodities are in contango (forward prices are higher than current spot prices), which puts a downward bias on the return to commodity futures and reduces our confidence in this source of returns. Nevertheless, we include commodities in risk parity portfolios, given the likely diversification they will provide (versus equities and bonds) if agricultural or energy commodities suffer from supply shocks. Equity style; the recent underperformance of value stocks could signify the erosion of a historic behavioural anomaly that has seen value stocks outperform growth stocks over many decades. Alternatively, it may represent a highly attractive opportunity for mean reversion. Given the robust performance of this premium over the very long term, we still believe this risk premium belongs in risk parity portfolios. However, we are investigating ways of broadening the value premium across other asset classes. Fulcrum Research Papers October 2012 7
Developed market currency carry; with interest rates close to zero across most developed economies, higher yielding carry currencies offer only a marginal yield pick-up versus lower yielding funding currencies. At the same time, the former are generally more overvalued. Although we expect developed market currency carry to generate a positive Sharpe ratio, our confidence in this potential return source is lower than it has been historically. Meanwhile, emerging market currency carry strategies continue to be underpinned by significant interest rate differentials between currencies, giving us relatively more confidence in the potential returns from this risk premium.
While the related problem of buying high and selling low applies to all assets within a risk parity portfolio (since volatility typically rises after price declines, and vice versa), it has historically been of much less significance to liquid premia. In addition, this problem can be moderated for liquid assets through option based hedging strategies, which we utilize in all of our risk parity portfolios. It is much more difficult to hedge illiquidity risk.
An equivalent approach is to first scale each asset (using leverage or cash) such that it targets the same level of risk and then allocate fixed weights across them. If the premias volatility is below the target, as tends to be the case with the bond premium, for example, leverage can be used to achieve the volatility target. On the other hand, if the premias volatility is above the target, as tends to be the case for the commodity premium, for example, exposure can be cut in favour of cash to reduce volatility.
For example, Figure 7 shows the distribution of monthly returns for S&P 500 Index futures, both before and after volatility targeting. To target 8% volatility, we use standard volatility estimates () that are based on recent realised returns and allocate a weight (w) to the S&P 500 Index, such that w* = 8%6. As can be seen, adopting a volatility target for the S&P 500 Index has historically improved skewness (the distribution is less negatively skewed) and kurtosis (the distribution is less fat-tailed). In addition, it has also increased the Sharpe ratio from 0.3 to 0.5. Figure 8 goes on to show how the volatility of returns for the S&P 500 Index is also much more stable after a volatility targeting approach has been adopted. Again, similar results can be shown for the majority of risk premia listed in Figure 5, including all the alternative risk premia. Figure 8: 3 Year Realised Volatility of S&P 500 Index Futures
25% S&P 500 Index Futures, without Volatility Target
20%
15%
10%
5%
0% 1995
1997
1999
2001
2003
The only notable exceptions are with credit premia, such as high yield corporate bonds and emerging market debt. Here, estimating volatility is a much more challenging task.
6
This is the methodology used in constructing the risk premia component of Fulcrum Alternative Beta Plus (FAB+). For example, if the volatility estimate for the S&P 500 Index is 20% at the beginning of a month, we invest 40% in the S&P 500 Index future and generate 40% of its return for that month. Correspondingly, if the volatility estimate is 10%, we invest 80% in the S&P 500 Index future.
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Approaches that use realised volatility as a guide to future volatility have tended to worsen the overall return distribution (Figure 9) and done little to stabilise the overall volatility profile. This is because they tend to be over exposed to credit before the onset of financial panics (reflecting artificially depressed volatility levels) and under exposed during the ensuing recovery (reflecting the sharp rise often by many multiples in realised volatility levels). The implication is that applying standard risk budget approaches to credit premia can result in a tendency to buy high and sell low. Figure 9: Monthly Return Distribution of US High Yield Corporate Bonds
45% US High Yield Index Return, without Volatility Target
40%
0% -18% -14% -10% -6% -2% 2% 6% 10% 14% 18% Source: Fulcrum Asset Management
Overall, volatility targeting helps normalise return distributions and improve riskadjusted returns for all premia listed in Figure 5, except for the credit premia. Importantly, once these (normalised) premia have been combined into a risk parity portfolio, the overall portfolios return distribution and risk-adjusted returns are also improved.
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10%
Alternative (ARP)
Traditional (TRP)
9%
8%
7%
6%
5%
4% 1995
1997
1999
2001
2003
As can be seen in Figure 10, TRP, ARP and RP have all delivered relatively stable realised volatility profiles that are generally close to the 8% target. The two asset BERP portfolio has seen a less stable volatility profile, reflecting the unstable correlation between equities and bonds. Overall, however, the volatility of diversified risk parity portfolios can be controlled effectively.
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Equity Premium
High Yield
Commodity Beta
1997
1999
2001
2003
For the bond premium, however, correlations vary significantly over time. As a result, we assume a zero correlation between major government bonds and other traditional risk premia. Over the last two years, this assumption has resulted in lower bond exposure than more traditional risk parity approaches. Going forward, we believe that 10 year bond yields will not sustainably remain below 1%, which limits the likely upside in bonds. Meanwhile, our approach is likely to be less vulnerable to rising bond yields. Fulcrum Research Papers October 2012 13
EM-DM Equities
Equity Size 0.1 0 -0.1 -0.2 Equity Style -0.3 -0.4 1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
-0.2
-0.4
-0.6 1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
14
Turning to alternative risk premia, Figures 12 and 13 show their low average correlation with a BERP portfolio. Importantly, this diversification benefit has increased since the financial crisis, reinforcing the valuable role played by alternative risk premia within risk parity portfolios. The tendency of these correlations to fluctuate in fairly wide bands around zero, leads us to assume a zero correlation between them and other risk premia.
How correlated are risk parity portfolios with equities and hedge funds?
Since the risk in most pension fund portfolios tends to be dominated by equities, approaches that are less correlated with equities are more valuable to most investors. As can be seen in Figure 14, TRP portfolios tend to be highly correlated (0.8) with equities while ARP portfolios tend to be uncorrelated (0.1). Figure 14: 3 Year Rolling Correlation with Equities
1
Equity/Bond (BERP)
-0.2
-0.4 1995
1997
1999
2001
2003
As shown in Figure 15, TRP and RP are more correlated with hedge funds than they are with equities. Nevertheless, we believe that investors considering risk parity funds should allocate from existing equity exposure, reflecting the dominance of equity risk in most portfolios.
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Figure 15: 3 Year Rolling Correlation with Hedge Funds (HFRI Fund of Funds Index)
1 0.9 0.8 0.7
0.6
Traditional (TRP)
0.5 0.4 0.3 0.2 0.1 0 1995 Alternative (ARP) Equity/Bond (BERP)
1997
1999
2001
2003
Annual Excess Return Volatility Sharpe Ratio Correlation with: Equity Premium Bond Premium Equity/Bond
16
700
Alternative (ARP)
500
400
300
200
100
0 1992
1994
1996
1998
2000
2002
The key highlights are as follows: Between 1993 and 2012, a risk parity portfolio of equities and bonds (BERP) has been highly correlated with both equity (0.7) and bond (0.7) premia. A portfolio of traditional risk premia (TRP) has underperformed BERP, reflecting its lower exposure to the bond premia. Meanwhile, rising correlations between credit, commodities and equities have resulted in a high correlation of TRP with the equity premium (0.8). A portfolio of alternative risk premia (ARP) has strongly outperformed BERP and has been uncorrelated with both equity (0.1) and bond (0.0) premia. A portfolio of all risk premia (RP), which combines ARP with TRP, has also performed well, with a moderately high correlation with the equity premium (0.6). Figure 18 shows the relative ranking of calendar year excess returns for each of the risk premia (excluding volatility). For example, so far in 2012, the best performing risk premium is high yield, while the worst performing is the equity style premium. While we continue to investigate ways of systematically timing risk premia, our current Fulcrum Research Papers October 2012 17
research suggests that timing is unlikely to work given the lack of persistence in relative performance. Figure 18: Calendar Year Excess Performance Ranking by Risk Premium (1997 2012)
97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 Equity Premium EM-DM Equities Equity Size Equity Style Commodity Beta Commodity Carry DM FX Carry EM FX Carry Bond Premium FI Carry EM $ Debt High Yield
Source: Fulcrum Asset Management
1st 2nd 3rd 4th 5th 6th 7th 8th 9th 10th 11th 12th
Importantly, however, a risk parity portfolio (RP) that combines all these traditional and alternative risk premia has generated positive returns in 11 out of the last 16 years, and in 3 out of the 4 years since the financial crisis (Figure 19). Figure 19: Calendar Year Profitability of Risk Premia (1997 to 2012)
Number of Positive Risk Premia 7 4 10 10 5 6 10 10 11 11 9 7 6 10 4 7 Number of Negative Risk Premia 5 8 2 2 7 6 2 2 1 1 3 5 6 2 8 5 Performance of Risk Premia Portfolio Positive Negative Positive Positive Negative Negative Positive Positive Positive Positive Positive Positive Negative Positive Negative Positive
Year 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997
18
19
Conclusion
Figure 20: Summary of Individual Risk Premia
Positive Sharpe Ratio Conducive Genuine Behavioural Correlation to Volatility Overall Risk Premia Anomaly (1997-2012) (2007-2012) to Equities Targeting Confidence
Return Source Traditional (Long Only) 1 Equity Premium 2 Bond Premium 3 EM $ Debt Spreads 4 High Yield Spreads 5 Commodity Beta Alternative (Long Short) 6 Emerging Equities (EM - DM) 7 Equity Style (Value - Growth) 8 Equity Size (Small - Large) 9 Fixed Income Carry 10 Commodity Carry 11 Developed Market Currency Carry 12 Emerging Market Currency Carry 13 Volatility
a a a a a a a a a a a
a a a a a a a a a a a a
a a a a a a a a a a a
High Low High High High Low Low Low Low Low Medium Medium Medium
a a a a a a a a a a a
High High High High Medium High Medium High High High Medium High High
a a
In this paper, we address some of the key issues faced by risk parity investors. Our main conclusions are summarised in Figure 20 and noted below: All thirteen liquid risk premia shown in Figure 20 should be included in risk parity portfolios, while illiquid risk premia should be excluded. There are some grounds for concern on expected returns for commodities beta, equity style and developed market currency carry. As a result, we allocate slightly less risk to these premia. Many traditional risk premia (excluding the bond premium) have become highly correlated over recent years, reducing their ability to provide diversification. Fortunately, alternative risk premia continue to provide an uncorrelated source of attractive risk-adjusted returns. Particular care should be taken when modelling volatility for credit premia given the tendency for their volatility to jump sharply. More sophisticated volatility models can help mitigate this problem. Selective use of the most stable correlations can improve portfolio robustness and performance. In our experience, the performance and volatility characteristics of risk parity portfolios can be improved further by adding alpha generating trading strategies and hedging overlays7. We will return to these in subsequent research papers.
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Disclaimer
This material is for your information only and is not intended to be used by anyone other than you. It is directed at professional clients and eligible counterparties only and is not intended for retail clients. The information contained herein should not be regarded as an offer to sell or as a solicitation of an offer to buy any financial products, including an interest in a fund, or an official confirmation of any transaction. Any such offer or solicitation will be made to qualified investors only by means of an offering memorandum and related subscription agreement. The material is intended only to facilitate your discussions with Fulcrum Asset Management as to the opportunities available to our clients. The given material is subject to change and, although based upon information which we consider reliable, it is not guaranteed as to accuracy or completeness and it should not be relied upon as such. The material is not intended to be used as a general guide to investing, or as a source of any specific investment recommendations, and makes no implied or express recommendations concerning the manner in which any clients account should or would be handled, as appropriate investment strategies depend upon clients investment objectives. Funds managed by Fulcrum Asset Management LLP are in general managed using quantitative models though, where this is the case, Fulcrum Asset Management LLP can and do make discretionary decisions on a frequent basis and reserves the right to do so at any point. Past performance is not a guide to future performance. Future returns are not guaranteed and a loss of principal may occur. Fulcrum Asset Management LLP is authorised and regulated by the Financial Services Authority of the United Kingdom (No: 230683) and incorporated as a Limited Liability Partnership in England and Wales (No: OC306401) with its registered office at 6 Chesterfield Gardens, London, W1J 5BQ. Fulcrum Asset Management LP is a wholly owned subsidiary of Fulcrum Asset Management LLP incorporated in the State of Delaware, operating from 767 Third Avenue, 39th Floor, New York, NY 10017. 2012 Fulcrum Asset Management LLP. All rights reserved. Fulcrum Research Papers October 2012 21